Here is the updated forecast calculator as it looks today. The point I am highlighting here is that price volatility was significantly more dynamic than changes in the company’s fundamentals (earnings).
So my message is straightforward and clear, judge your holdings by how well their businesses are performing rather than what an often “schizophrenic” Wall Street may be saying. If fundamentals are good and the price falls, hold or buy more as appropriate. If the price rises to unjustifiable valuations, sell and replace to protect against risk regardless of fundamentals.
I believe and realize that attempting to forecast markets or stock prices in the short-run is an exercise in futility. Short-term market movements are driven and dominated by emotion and not rational thought. At any given moment in time, the powerful emotions of fear or greed can and will overshadow reason. However, in the longer-run, rational thinking and fundamental strengths prevail. The following Warren Buffett quote speaking about Ben Graham summarizes my views:
“Ben Graham said you should look at stocks as small pieces of the business. Look at (market) fluctuations as your friend rather than your enemy – profit from folly rather than participate in it. He said the three most important words of investing: “margin of safety.” I think those ideas, 100 years from now, will still be regarded as the three cornerstones of sound investing. Warren Buffett”
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Is the Stock Fairly Valued or a Value Trap
To add clarity to the thesis of this article, I am advising that investors focus more on fundamentals than short-term stock price movements. The true message underpinning the Marty Whitman quote I presented above can be better understood by thinking about the timing of real information versus daily and hourly price variations.
Companies report earnings quarterly or only four times a year. I contend that it is primarily through these quarterly financial reports where relevant information about a company and its fundamental health can be found. As previously stated, in the short run, stock prices are often pathological liars. Additionally, stock price volatility is relentless and continuous.
Consequently, I do my best to ignore short-term price volatility other than to measure it against the fundamental valuations that I see in each company I invest in. However, I am keenly focused on evaluating the company’s financial performance when each quarterly report is posted. Sometimes the real news is good, and sometimes it’s not so good. However, it is only at these times that I began drawing a conclusion regarding whether I will buy, hold or sell.
I recently received a suggestion from a reader and F.A.S.T. Graphs™ subscriber to write an article featuring Chicago Bridge & Iron Company N.V. (NYSE:CBI). The reader suggested that this company would be a case study of a value trap. If I understood him correctly, he invested in the stock thinking it was undervalued based on what he saw on the earnings and price correlated graph. However, the company has continued to decline. Nevertheless, I think it represents an excellent example behind the thesis of this article.
The following operating earnings and price correlated graph on CBI since the beginning of 1998 tells an interesting story regarding the long-term relationship of stock price to fundamentals. First and foremost, we see that in the long run price follows earnings (the orange line on the graph). We also see the price collapse and that the dividends were cut during the Great Recession when earnings also went negative.
The black line on the graph is a plotting of monthly closing stock prices. This is important because with only 12 dots connected for each year we get a perspective of the trend of stock prices over time. This would be in contrast to a graph showing daily price action which would be significantly more erratic or jagged. Nevertheless, we still see short periods of time where stock prices rise and fall and become disconnected from fundamental value.
However, in the longer run, we see stock prices clearly moving in tandem with earnings. To me, this illustrates the importance of fundamentals (earnings in this case) over price action in the long run. On the other hand, since April of 2014 the disconnect between stock price and earnings appears more pronounced than at any other time over this long-term timeframe. It should also be pointed out that earnings are forecast to fall 17% for this fiscal year and another 6% for fiscal 2017. Therefore, at first glance, this provides a partial explanation of the recent price action.
